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Jul 23, 2018

Anatomy of a Mortgage

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Looking for a home? Imagine you are on your lunch break at work and you discover a new home on the market that seems to be a perfect fit. Fast forward to that evening when you are the fourth person to tour the home. You’ve fallen in love with it already, but you find out that there are already two offers on the table. Plus, the sellers will stop accepting offers at noon tomorrow.

Things move fast in today’s housing market. For many homes, especially those in the most affordable range, the scenario above is all too real.

While the housing market will not always move as fast as it is today, it’s always good to understand what you’re getting into with a mortgage loan (even if it’s just a refresher) so you're ready to take quick action when you find the perfect home you've been searching for. Being prepared may make all the difference - read more and check out our example of the real price of a $250,000 home.

Pre-Approval – Before you place your offer on a home, you should already have narrowed down potential lenders and have a pre-approval letter in-hand. In fact, many realtors and selling parties will not work with you until you have a pre-approval. Getting pre-approved for a mortgage is typically free. It will, however, result in a pull on your credit since the lender you are working with will need to review your credit history as part of the process. Remember - getting pre-approved for a certain amount doesn't mean it is best for you to take a loan for the full amount but is more a measure of what the lender is comfortable offering you. You should strongly consider additional financial factors when deciding how much loan you can afford - more on all the potential expenses later.
Earnest Money – Think of this as a security deposit on your mortgage offer. It shows sellers that you are interested in their property and not putting in offers for every house you see (because, even if you want to be the next HGTV home renovation show, you probably can’t realistically buy them all). A typical amount to put down in for earnest money is $1,000. While you will need to pay this out-of-pocket when you make an offer, you will typically see it as a credit to your closing costs. You may also be able to get this money back if you withdraw your offer due to findings during a home inspection as long as you make that a contingency of your offer.

Contingencies – A contingency is a situation or circumstance that you specify must be done before your deal is final. While they are not an expense of a mortgage, they could save you from unexpected expenses later. Common contingencies include a home inspection, selling an existing home, appraisal, and financing. For example, including inspection results as a contingency of an offer would allow you to either make a counter offer or rescind it entirely if the inspection identifies significant issues or concerns with the home that you don't want to tackle as the owner. Of course, the more contingencies included in an offer, the less appealing it may be to a seller who is looking to sell quickly or without potential holdups.

Loan Estimate – Once you've put in an offer, you can request a loan estimate from your lender (or potential lenders if you haven’t made that decision yet). Within three business days, the lender will send you a document giving you details about loan terms, projected payments, and estimated closing costs for the loan amount you have requested. The document will also let you know if you can (and how long you would have the ability to) lock in the interest rate on the mortgage.

You can use the information you receive to choose the lender that is right for you. Keep in mind, though - a loan estimate is not a pre-approval if you choose to move forward but a helpful tool to understand estimated financial obligations.
Inspection Fees – If you choose to make an inspection a contingency of your offer (it’s highly recommended to help prevent any not-so-pleasant surprises once you move in), you’ll need to pay the fee at the time of the inspection. While the cost of inspections can vary based on many factors (the size of the home, location, experience of the inspector, etc.), you can expect to pay somewhere in the range of $300-$500 at a minimum. There may be additional fees if you decide to test for radon (a naturally-occurring gas that enters a home through cracks in the foundation), mold, or asbestos.

Your realtor should be able to help you coordinate an inspection with a reputable inspector they’ve worked with previously.

Appraisal – Your lender will have a professional evaluate the property to ensure that its worth is in line with the amount you have offered. The fee for this appraisal will typically be included as a closing cost. If the appraisal finds that your offer is overpriced (even if it is what the home was listed for), they will not lend more than the appraised amount (minus the minimum down payment).
Down payment – While you should put as much down on a home as you can comfortably afford to do (no borrowing from your emergency fund, folks), you could pay as little as 3% of your home’s purchase amount through a first-time homebuyer’s program (like the one Firefly offers).  

Putting more down reduces the overall loan amount and, in turn, your monthly payment and the total interest you’ll be charged on your loan. It may also shorten the length of time you’d need to pay for private mortgage insurance (PMI - more on that later) if you put less than 20% down on a traditional mortgage - be sure to ask about this, though. If you've purchased a home in the past or are looking into a more unique situation like buying land to build on, expect your minimum down payment to be between 5-20% of your home’s purchase price.

Closing Costs Closing is a whirlwind of document signing for all parties involved in buying or selling a home and formalizes the change in the property ownership. When it’s all said and done, you’ll be the owner of your new home and you’ll be obligated to repay the mortgage. Some of the common expenses you’ll pay at closing may include:
  • an origination fee - typically 1% of the purchase price; covers the costs of the lender processing the loan)
  • the cost of obtaining a credit report
  • underwriting fee (for preparing paperwork associated with the loan)
  • appraisal fee
  • flood insurance (if necessary)
  • and more
Altogether, these fees (separate from your down payment) typically add up to around 3% of the purchase price of your home.

Realtor Fees – When you buy a home, you typically won’t need to pay a realtor’s commission. Instead, this is an expense taken on by those who are selling the property. You can estimate about 6% of the home’s purchase price for this commission – something to keep in mind if you are also selling the home you currently live in. To put that into perspective, that’s about $15,000 on a $250,000 home.
Unfortunately, owning a home doesn't just include paying back the mortgage to the lender. Additional expenses should be factored in when deciding how much home you can afford.

Principal – This is the portion of your monthly payment that will be applied to the actual balance of your loan (excluding interest).

Interest – This is the cost to use the money that your lender gave you for your loan. Interest is calculated based on the outstanding amount of your loan. Because of this, what you pay in principal and interest will change throughout the life of your loan; it's something you likely won’t notice when looking at your overall monthly mortgage payment. You’ll pay more in interest charges toward the beginning of your loan. When the balance of your loan has decreased to a certain extent, this will flip and more of your monthly payment will go toward the principal.

Depending on your unique situation, you may decide that an adjustable-rate mortgage (or ARM) is right for you. With this type of loan, your mortgage's interest rate can fluctuate once your fixed-rate period ends (and not always in a way that benefits you). This loan type may work for you if you know that you only plan to stay in a home for a set number of years (temporarily relocating for a job, for example) to take advantage of a lower rate environment. It's always a good idea to speak to a loan officer to­­ help decide what financing type works best for your unique situation, though.

Property Taxes – This is the portion of your monthly expenses that is paid to the county that you live in. Each year the county will assess property taxes based on a variety of factors including the fair market value of your home, local government budgets, school referendums, etc.. So, expect this amount to fluctuate year-to-year. Tax rates are currently about 1.17% in Minnesota (close to the national average) and vary based on your location; they are usually higher in urban areas and less in rural areas. You should receive a mailing twice annually from your county – a statement in spring with tax amounts for the current calendar year and a notice in fall with proposed amounts for the upcoming calendar year.

Homeowners Insurance – This is the portion of your monthly expenses that goes toward the insurance policy that you choose for your residence. You may be required to, or choose to, include different things in your coverage depending on a number of factors (the property type, the age and size of the property, number of people living in the home, common natural disasters in your area, if you have pets, a pool, etc.). The cost of this coverage will also vary based on your credit, insurance claims history, if you carry other insurance policies that you can bundle with the company, and how much coverage you want to have. The nationwide average premium cost for homeowners insurance in 2015 was about $1,200 annually.

If you paid less than 20% of your home’s purchase price, you’ll likely be required to pay your homeowners insurance and property taxes through an escrow account (an account set up with your lender that collects the portion of your mortgage expenses designated for property tax and homeowners insurance; you pay into your escrow account as part of your monthly mortgage payment to the lender). When taxes or insurance payments are due, your lender then pays them directly from your escrow account. You may be asked to pay a certain amount to your escrow account in advance (for example, Firefly asks for a year’s worth of tax and insurance payments at closing).

Private Mortgage Insurance (PMI) – If you paid less than 20% of the price of the home as your down payment, you will need to pay PMI. This is different than homeowners insurance and helps to protect the lender in the event that you foreclose on your home. If you had a traditional-type mortgage, you can request to remove PMI once you’ve paid 20% of the purchase price of your home. If you have an FHA loan, you may not be able to remove this until a certain point in your loan so be sure to ask about this when deciding what type of mortgage may be best for you.

Fees – Depending on the type of home you choose, you may have additional monthly or annual fees for upkeep of the property (including buildings repairs and maintenance, shared spaces, and grounds). For example, you may have an association fee for a townhome; you may see this referred to as a HOA or homeowners association. Co-ops and condos will likely also have additional fees for owners. Understand what these may be for your home and factor them into your financial obligations as a homeowner.

Other Monthly Expenses – Like anywhere you live, you need to pay for more than the space itself. Expenses like utilities (heat, electricity, water, sewer, garbage, recycling, yard waste, etc.) are all things you will be responsible to pay as the owner of a home. There are additional monthly expenses for other services that make life more convenient like internet, lawn care, snow removal, etc. that you’ll also want to consider when it comes to determining how much house you can afford.

When it comes down to it, buying a home is an exciting time. However, you’ll want to make sure that your decision is not putting your overall financial health or stability at risk, as the final price you’ll pay is vastly greater than the purchase price of a home. You should also consider how this purchase will impact funds that you have available for other things in your life – now and in the future:
  • Would the home you want leave you enough leftover each paycheck to get by comfortably or would you need to change your lifestyle to cover the costs?
  • Would the costs of the home prohibit you from continuing to save for things like retirement, a wedding, a family vacation, a new vehicle, a child’s college education, etc.
  • Would an unexpected, major expense like a car accident, broken appliance, or medical expense make it impossible to pay your mortgage and pay off the additional expense?
  • Would your mortgage expenses leave room in your budget to make improvements to the home and property including routine maintenance?
  • If you are purchasing with anyone you are not legally tied to (i.e. marriage), have you discussed (and documented with the help of a real estate lawyer) expectations for mortgage expenses as well as any other situations that may arise down the line (profits from a sale, if one co-owner wants to sell, if a co-owner can’t pay your portion of the mortgage, etc.)?
Asking yourself questions like the ones we've offered will help you determine if you are really ready for a mortgage. If you aren’t sure, a loan officer at your local credit union or bank or your financial advisor are great resources to help you take a closer look at your finances.

Contents of this blog article are intended to provide you with a general understanding of the subject matter. However, it is not intended to provide legal, accounting, or other professional advice and should not be relied on as such. Information may have changed since the publication date.

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